Presented By:

August 16, 2016

THE PROFITABLE SIDE OF RISK MANAGEMENT

Robert Perry

Principal, ALM & Investment Strategy

Agenda

• Risk management– Why it’s important

– Volatility• Inputs

• Four concepts and practices risk managers should understand:– Mortgage pipeline hedging

– Marginal ROE analysis

– Risk-targeting & capital management

– Benchmarking with peer analysis

2

What is Risk Management and ALM

• asset-liability management – risk management process for decision making with the purpose of reducing risk and increasing returns

• Risk management ultimately centers on profitability through risk reduction

• Goal: maximize the firm’s probability-weighted net worth

3

Who Cares and Why?

• Regulators– ALM is a huge regulatory-driven focus

– FFIEC (OCC and NCUA)

– Interest rate risk and market risk

• Managers– Managers’ compensation should be tied to the value they add to

the firm

– Improving ALM process can add significant value

• Stakeholders– Shareholders have an obvious interest in firm profitability

– Members also benefit from a profitable organization

– They both have an interest in the safety of the firm

4

ALM Framework

• Maximize expected probability-weighted present value of net worth, subject to constraints

5

PV of  Net Worth

t = 0 t = 1 t = 2…N

Net Income Net Income

Revenue Revenue

Costs Costs

Volatility of Model Inputs

• All models are subject to input variability

• Non-stationarity

• Higher variability = less predictability– Requires greater capital charge

• Caveat Emptor—mileage may vary

6

CONCEPTS AND STRATEGIES:

MORTGAGE PIPELINE MANAGEMENT

7

Mortgage Banking Business

• The mortgage banking business involves:

• Commitments made to potential borrowers are firmfor the financial institution, but flexible for the borrower

8

Originate New Loans

PipelineManagement

Service Sold Loans

(MSR)

Mortgage Pipeline Risk

• Mortgage originators sell conforming mortgage loans to the agencies (GNMA, FNMA or FHLMC)

• This sale process exposes the originator to pricing risks from the time of the initial commitment to the borrower until the time that the mortgage is committed for sale to the agencies

• Originators manage this pipeline risk in one of three ways:– Best efforts forward sale commitments

– Mandatory forward sale commitments

– Hedging their pipeline with capital market instruments like TBA MBS and other interest rate related futures contracts

9

Pipeline Management

• Best efforts commitments: – Loans are committed or “locked in”

– If the loan does not close, delivery is not required

– Least favorable pricing

• Mandatory forward whole loan or cash sales:– Mandatory delivery

– If delivery cannot be made, there is a “pair off” fee

• Hedging the pipeline with capital market instruments like TBA MBS

10

Pipeline Management

• Choosing the technique to employ involves cost-benefit analysis

• Performance evaluation should consider not only mitigation of risk, but cost effectiveness of doing so

• High quality pipeline management should:– Effectively mitigate risk

– Be cost efficient

– Be transparent

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Performance

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CONCEPTS AND STRATEGIES:

MARGINAL ROE ANALYSIS

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Marginal ROE Analysis

• Relative value technique for sector selection

• Helps with capital management

• Where capital meets profitability

• Assists in:– Sector selection (relative value)

– Analysis of profitability by business line

– Risk-budgeting

14

ROE Analysis for Sector Selection

• Marginal ROE analysis can be used to analyze relative value by sector

• Data needed:– Market-based offer rates (national averages)

– Market-based servicing costs

– Market-based credit information

• Targeted capital level: 10%

15

National Offer Rates

• Credit unions offer rates lower across the board

• Most notably, auto loan rates are significantly lower

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National Offer Rate Averages – June 30, 2016

Asset Class US Avg Credit Unions Difference

New Auto 3.77 2.72 -1.05Used Auto 3.93 2.90 -1.03HELOC 4.25 4.06 -0.19Home Equity 5.05 4.88 -0.17RV 5.53 4.91 -0.62Boat 5.51 4.88 -0.63Credit Card 11.24 10.29 -0.95Unsecured 36mo 9.66 9.23 -0.431Yr ARM 3.09 2.82 -0.273/1 ARM 3.23 3.00 -0.235/1 ARM 3.27 3.07 -0.207/1 ARM 3.40 3.31 -0.0915Yr Fixed 3.07 3.03 -0.0420Yr Fixed 3.52 3.52 0.0030Yr Fixed 3.72 3.70 -0.02

National Net Charge Off Data

• NCO data can help gauge market-wide credit loss estimates

• CU net charge offs in Q1 2016 are also lower across the board compared to banks– Keep in mind: CU data aggregates CRE with 1st lien

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National NCO Weighted Averages - Q1 2016

Asset Class Banks Credit Unions Difference

1st Lien 0.07 0.01 -0.062nd Lien 0.46 0.03 -0.43Auto 0.68 0.16 -0.53Credit Card 3.13 0.56 -2.57CRE 0.00 NA NAHE 0.31 NA NA

Profitability

• Risk management– Quantify the risks inherent in asset or liability

• Credit - charge offs are volatile over time

• Interest rate risk

• Options

• Liquidity

• Establish confidence interval around risk estimates– Conduct sensitivity analysis on key assumptions

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Risk Adjusted Analysis

• Price competing products given the identified risks and maximize profits– Consider competitor rates but you must individually analyze

given your assumptions• Cost structure

• Risk analysis

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General Decision Rules

• When considering alternative loans / investments:– Same risk characteristics – choose the option with higher

expected return

– Same return characteristics – choose the option with lowest risk

– Expected return should exceed marginal funding costs

• Consider each alternative in the context of the entire balance sheet– Quantify diversification benefits

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Asset-Class Expected Return Rank-Ordering

• Consumer: – Buy: unsecured / credit cards

– Sell: auto loans

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Marginal ROE Rank Order - NationalAsset Class US Avg Service Cost

Unsecured 36mo 49.85 1.00RV 49.11 0.25Boat 48.85 0.251Yr ARM 39.91 0.253/1 ARM 37.83 0.25Credit Card 37.30 1.005/1 ARM 35.18 0.257/1 ARM 35.05 0.2530Yr Fixed 33.55 0.2520Yr Fixed 30.06 0.25Home Equity 29.05 0.50Used Auto 27.99 0.25New Auto 25.89 0.25HELOC 25.85 0.5015Yr Fixed 22.58 0.25

Marginal ROE Rank Order - Credit UnionAsset Class Credit Unions Service Cost

Credit Card 55.57 1.00RV 47.73 0.25Boat 47.43 0.251Yr ARM 39.93 0.253/1 ARM 36.33 0.255/1 ARM 34.68 0.2530Yr Fixed 34.55 0.257/1 ARM 34.23 0.25Home Equity 31.60 0.5020Yr Fixed 31.30 0.25HELOC 26.83 0.5015Yr Fixed 23.26 0.25Used Auto 21.30 0.25New Auto 18.95 0.25Unsecured 36mo NA 1.00

• Mortgage:– Buy: ARMs

– Neutral: 30 Year, HE

– Sell: 15 Year, HELOC

Important Questions

• What is the institution’s desired risk profile?

• What are the effects of changes in interest rates and economic conditions on earning and capital?

• Is the institution’s expected return maximized for the level of risk?

• Is the institution using the capital efficiently?

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CONCEPTS AND STRATEGIES:

RISK-TARGETING & CAPITAL MANAGEMENT

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Capital Management

• Capital management involves targeting a level of capital and allocating it efficiently

• Risk-based and leverage capital

• Risk-based capital (RBC) is a regulatory framework for capital allocation by business line

• Best practice dictates capital allocations should be done at a more granular-level– Regulatory RBC framework is one-size-fits-all

– Capital charge should be dependent on risk of the asset• Expected versus not-expected loss, i.e. input variability

• An asset that does not meet the expected marginal risk-adjusted return requirement should not be added to the balance sheet

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Risk-Based Capital

• Capital management involves targeting a level of capital– E.g. well-capitalized threshold

• Risk-based and leverage

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NCUA

Risk Category RBC RatioNet Worth

Ratio

Well Capitalized 10% And 7%

Adequately Capitalized

8% And 6%

Undercapitalized <8% Or ≥4%; <6%

Significantly Undercapitalized

NA ≥2%; <4%

Critically Undercapitalized

NA <2%

FDIC

Risk Category Total RBC Ratio Tier 1 Lev Ratio

Well Capitalized 10% 5%

Adequately Capitalized

8% 4%

Undercapitalized <8% <4%

Significantly Undercapitalized

<6% <3%

Critically Undercapitalized

Tangible Equity/Total Assets ≤ 2%

Risk Weightings and Capital Allocation

• Example: – First lien mortgage risk weighting: 50%

• Required capital allocation = (50%) * (8%) = 4%

• To maintain adequate capitalization and considering adding $50mm in first lien mortgage loans, the dollar amount of capital:– 4% * $50mm = $2 million

Risk Weight

Capital Target

Capital Allocation 

(%)

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Balance Sheet Optimization Techniques

• Mean-variance optimization– Selection of assets from asset “universe” with highest expected

return given a targeted risk level

• Objective: maximize ROE

• Constraints: – leverage and risk-based capital

– ∑ W1+W2+W3 etc = 100%

– All Weights (Ws) ≥ 0 • No short selling

– Concentration targets

– Operational constraints

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Mean-Variance Optimization, Example

• Economic Value (IRR) targets– Sensitivity: 25%

– Ratio: 8%

– Duration gap: 5%

• Capitalization targets– Leverage: 7%

– RBC: 10%

• Concentration targets– Loans: 70% assets, mortgages < 50%, etc.

– Investments: < 30% assets

• Operational constraints– Marginal analysis must include asset-specific servicing costs

– Must incorporate expansion costs (new hires, buildings, etc.) if necessary

– Example: limit growth of mortgages to 50% of loans due to operational constraints, unless new capital investments are planned

• Resulting balance sheets form the efficient frontier

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Efficient Frontier, Model Balance Sheets

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Efficient Frontier

ROE

Risk

Balance Sheet ARisk: Low

Balance Sheet BRisk: Moderate

Balance Sheet CRisk: High

The efficient frontier is formed from the balance sheets that have the highest expected return given a level of risk; subject to constraints, e.g. concentration and capitalization targets, etc.

CONCEPTS AND STRATEGIES:

BENCHMARKING WITH PEER ANALYSIS

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Where does Profitability Come From?

• Achieving a 12% ROE is generally accomplished through incremental improvements in multiple areas– Singles versus home runs

• Sources of profitability can be thought of as either adding to cost efficiency or topline revenue– Cost efficiency:

• Cost of funds

• Op-ex (efficiency ratio)

– Topline revenue

• Loan and investment management

• Fee income

• Profitability strategy targets areas with greatest value-add potential

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Where does Profitability Come From? (continued...)

• Profitability can be generated:– Above the line

• Interest income– Lending operations

– Investment portfolio management

• Interest expense– Deposit franchise

– Below the line• Non-interest income

– Fee-generating strategies

• Non-interest expense (op-ex)– Cost control strategies

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Industry Benchmarking: ROE and ROA

• Weighted by asset size

• Industry ROE:– Community banks: ~9.61%

– Credit Unions: ~7.30%

• Industry ROA:– Community banks: ~1.11%

– Credit Unions: ~0.75%

• Industry Net Interest Margin:– Community banks: ~3.47%

– Credit Unions: ~3.27%

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Industry Benchmarking: DuPont Model

• Weighted by asset size

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Return on Equity: Component Analysis

MetricCommunity

BanksCredit Unions

Return on Equity 9.61 7.30Return on Assets 1.11 0.75Net Interest Margin 3.47 3.27

Net Profit Margin (% of Total Revenue)Total Revenue 100.00 100.00Interest Expense 8.33 11.73Provision for Loan Loss 2.73 6.88Non-Int Expense (Efficiency Ratio) 60.21 65.34Tax Expense 6.38 NANet Profit Margin 22.35 16.05

Asset Utilization (% of Average Assets)Interest Income 3.85 3.38Non-Int Income (%) 1.29 1.36Asset Utilization 5.14 4.74

Leverage MultiplierLeverage/Net Worth Ratio 10.77 10.65Leverage Multiplier 9.17 9.81

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Interest Rate Risk Distribution: NII Volatility

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0

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NII Volatility – Up 300

Interest Rate Risk Distribution: NEV Percent Change

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NEV Percent Change – Up 300

Interest Rate Risk Distribution: Up 300 NEV Ratio

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NEV Ratio – Up 300

Putting It Together: Risk-Adjusted Financial Performance

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0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

Ret

urn

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y (R

OE

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Standard Deviation (σ)

Top 20 Average ROE

Top 20 Average ROE Volatility